What is a Standby Letter of Credit?
A Standby Letter of Credit (SBLC) is a legal document that guarantees a bank’s commitment of payment in favor of a beneficiary in the event that the applicant defaults on the payment. An SBLC helps to facilitate commitment of payment between entities that do not know each other and have different laws and regulations.
The procedure for obtaining an SBLC is similar to an application for a loan. The issuing bank issues the SBLC as a payment guarantee in favor of the beneficiary only after appraising the creditworthiness of the applicant and securing the collateral. The collateral will be held by the bank until the maturity of the SBLC.
Upon the SBLC maturity date, the beneficiary will demand the payment to the applicant. In the event that the applicant default to make the payment, the beneficiary will present the SBLC to the issuing bank. The issuing bank will then take over to make the payment and take over the collateral. Thus, the beneficiary is guaranteed to be paid.
Typically, the bank will issue an SBLC amounting 85% – 90% of the collateral value. The application pays a fee for each year throughout the validity of the SBLC amounting 1% – 2% of its face value.
An SBLC is the most desirable banking instrument to leverage businesses by acting as an alternative funding source with minimum risk. When a beneficiary obtain a transferable, irrevocable and unconditional SBLC from an applicant / provider, the beneficiary may choose to resell the SBLC to an SBLC monetizer.
Typically, a monetizer will disburse 70-80% loan to the SBLC beneficiary depending on the issuing bank’s credit rating and the location. On the other hand, the SBLC beneficiary shall only pay 35% – 55% purchase fee to the provider. Therefore, the beneficiary can take advantage of the margin.
Since a bank is taking a risk by offering an SBLC, there are fees to obtain one. Typically, banks will charge a certain fee for issuing the SBLC. On top of that, the SBLC provider will charge a fee for issuing the SBLC depending on their procedure.
An SBLC is the most desirable financial instrument for companies seeking for an alternative funding source. With the backing of an issuing bank, an SBLC offers reassurance that an agreement will go through, even in a worst-case scenario. However, obtaining an SBLC is not without cost, there are fees and due diligence process before obtaining one.